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Thursday, June 14, 2012

Todd Henderson of the University of Chicago Responds to Criticism of his Regulatory Proposal to Give Bank Regulators Compensation Based on the Performance of the Banks They Regulate

Earlier this Forum published
a commenton a proposal by Prof. Todd Henderson of the University of Chicago to incentivize bank regulators
with bonuses and phantom equity in the very institutions that they regulate and bonuses based on institutional performance. We thought it was a very bad idea, actually a
very stupid idea.

So in fairness here
is the entire response Mr. Henderson made to the Post.

If
the "Dismal Political Economist" bothered to read the paper I (along
with Fred Tung of Boston University) wrote, (s)he would have learned that we
proposed paying a bonus to bank regulators tied mostly to bank debt in order to
give regulators incentives to act more aggressively to restrict bank risk
taking. But I guess it is easier to criticize a paper we didn't write instead
of the one we did.

If anyone is reading this blog -- and I have my doubts given this kind of
sloppiness -- you can read the paper for yourself here:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916310.

Well Professor
Henderson is correct in that we did not read his paper, mostly because we
did not know such a paper existed since the news article in Businessweek that
generated the post did not reference a paper.
Of course it is only fair to point out in our defense that now that we have read this paper we still reach the same conclusion.

Compensating
regulators by providing them with phantom equity positions in the companies
they regulate or by incentivizing them with respect to regulating risk is an unworkable concept, or at least one
Mr. Henderson and his co-author have not worked out. The fact that they are
confident things can be worked out does not work out for the rest of us.

We
are confident that the optimal mix can best be determined

through
trial and error. Potential error costs, however, counsel

for
a gradual implementation of our proposal. Unlike executive

compensation,
where experimentation can and does occur among

thousands
of private firms, and a given firm’s poor pay design

would
be unlikely to have widespread impact, error costs may be

high
with regulator incentive compensation design. There are only

a
few bank regulatory agencies, and a significant design mistake

could
affect the entire banking sector, and perhaps beyond. Agency

heads
should therefore proceed slowly and incrementally. The appropriate

debt-equity
mix is an area for which more study and a

conservative
approach are likely warranted.

Ah yes, the famous “more study is needed” answer to
questions of practicality.

And even if it were somehow practical it is a really
bad idea.(and in the interests of harmony we will drop the assertion that it is a stupid idea, apologize for using that term and simply claim that it is an impractical idea.)

It is long and it
is well written and well researched. It
is full of footnotes (162 to be exact) and citations, which we like, and it
is totally and completely in error of its basic supposition, that somehow financial regulators will be
more effective if they have incentive compensation based on performance of the institutions
they regulate. It is also beyond the
scope of this Forum and this post to comment completely on the paper, we must
leave that for those who do that sort of thing once a paper is published. But we can say a few things.

The very premise of the paper is one of the things
that is false. The premise is that
regulators can in effect micro manage a financial institution. This is not possible and it is not their jobs
and it violates about every principle of non state owned business management
that exists. . The job of Congress is to set broad parameters of regulation. The regulatory
agency's job is to set forth rules, regulations, practices and procedures that the
industry subject to regulation must follow.
The job of the examiners is to observe and monitor and report to see
that the institutions are following those rules.

Mr. Henderson and Mr. Tung have come up with an entirely
new definition of regulation. They make regulators quasi-executives, which
is a radical departure from the role of examiners and individual
regulators. By going further, and
providing for a large part of the compensation of these examiners to be dependent
upon performance of the institution, they essentially turn regulators into
managers whose focus is not longer enforcing regulations, but whose focus is on
the performance of the securities of the entity they are examining.

This position is premised in part on the principle
that the market is completely efficient, and that the prices of the securities (the common stock, bonds, CDS's etc) of financial institutions fully reflect the risk and return in those
institutions. This premise will come as
a surprise to investors in Bear Stearns, Lehman Brothers, Washington Mutual, Bank of America and
so forth. Could regulators really have prevented J. P. Morgan Chase from losing a couple of billion in hedging that wasn't hedging? Heck J. P. Morgan Chase didn't even understand what they were doing, it would have been impossible for regulators to do so. Mr. Henderson and Mr. Tung think Credit Default Swaps could be used in the compensation scheme. If regulators really understood CDS's they wouldn't exist in their current role in the first place.

The paper and its policy recommendations are the very epitome of an excellent academic paper. It is very well constructed and it has no applicability or understanding of how the world really works.

6 comments:

You're right, of course, as always. This proposal is perhaps the best example of academic capture, and by extent, regulatory capture, that could possibly be made. I can't believe anyone pays these two a salary!

This is the same Mr. Henderson who whined about his inability to provide for his family on $ 250,000.00 per year and threatened to go Galt if his taxes were raised. This must be his way of pleasing Grover.

Thank you for reading and confronting the paper head on. I appreciate that.

I think you misunderstand banking regulation. You are right that what we describe as the role of banking regulators is not the typical sort of regulation, which you rightly describe. Bank regulators have a very different function. They have enormous power to shut down banks or bank activities based on an analysis of risk. The bank examiner manuals for the regulators and the post mortem reports of banks done by inspectors general make this abundantly clear. In a working paper with James Spindler (Texas) that is not yet published, I am developing a formal model of this sort of regulatory model, pointing out the inherent problem with it. But that is for another day.